How do you grow your way out of debt?

Dec 19, 2014

Washington, DC

Dear Diary,

Janet Yellen made headlines yesterday. She said she'd be patient about 'normalizing' interest rates. But investors must not have known what she meant. Half thought it would be good for stocks - with the Dow up more than 300 points. The other half thought it meant higher rates sooner than expected; they sold their bonds, the biggest sell-off in 17 months.

Investors give Ms. Yellen far too much credit. Will she raise rates soon...or late? She probably doesn't know herself. She is just reading the newspapers as we do, and wondering when she can get away with it. She looks in the mirror in the morning and gasps...incredulous of the way people overestimate her. She knows...at least, before putting on her makeup...that the whole thing is nothing but face paint and false accounting. She just doesn't want to be the Fed chief who has to admit it...the one who finally pops the bubble and brings on a depression.

Meanwhile, the news yesterday was dominated by one thing that was improbable and one that was inevitable. The US is finally lightening up. After half a century, it was clearly time for America to let go of its abiding dislike of the Castro regime. In the light of history, he doesn't look so bad. After all, plenty of movies have been made featuring a Fidel-like character; never once did he threaten to blow up movie theaters.

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Besides, Cuba will be more fun to visit than North Korea. Imagine a country almost untouched by modern conveniences and the progress of the last 50 years. No shopping malls, billboards, freeways, speed traps, Howard Stern, blue states, red states, terror alerts, student debt, Obama care or QE.

Sounds pretty good, doesn't it? And imagine a country where you can lose 100 pounds in 5 years at public expense. This is sure to be a big hit with Americans when it opens to the public.

But today, we continue with our look at the macro situation at the end of 2014.

GDP is measured by adding expenditures - consumption, investment, government spending, and net exports. GDP = C + I +G + (X-M)

US GDP is currently reported to be $18 trillion, with $3.5 trillion of that in the form of US federal spending. Add state and local government spending and the total rises to over $6 trillion. This means that the private sector - the part that pays the bills - is only $12 trillion.

Total debt in the US is now $58 trillion (misreported yesterday as $60 trillion...but what's a couple trillion dollars, more or less?) That's nearly 5 times the real economy that supports it.

This helps explain why it is so hard to 'grow your way out' of a lot of debt. Even if you could contain debt increases to 3% of GDP per year, the productive part of the economy would have to grow at 5% just to stay even. No developed economy in the world is growing that fast.

At an average interest rate of 3%, the annual interest on $58 trillion is $1.7 trillion. That's slightly less than 10% of GDP, but it's 14% -- or one of every seven dollars - of the private sector economy.

And as recently as January 2002, the 10-year Treasury note yielded over 5%. If the average interest rate were at that level again - and it will be, sooner or later - it would take $3 trillion to service America's debt, or a quarter of the private sector's output.

That can't happen. The wings would fall off first. Typically, there would be a bear market in stocks and a depression in the economy - wiping out trillions worth of unpayable debt and unworkable investments. That is how nature deals with debt bubbles. But it's exactly what the Fed wants to avoid. How? By trying to make the economy grow faster, so that debt - as a percentage of output - is less of a burden.

But let's see, how does this work? In order to grow your way out of debt you have to increase income faster than debt. Say you can sustain a healthy rate of GDP growth of 3% per year. That means that additional debt mustn't exceed 3%.

The US fiscal 2014 deficit was 2.8%. It is unlikely to go much lower. And that is just the amount borrowed by the feds. The private sector is still 2/3 of the economy. And if it borrowed nothing, debt might actually contract, relative to the underlying economy. But without borrowing, the economy will not grow; it will shrink. That is why the feds stepped up to the plate in 2009 and started swinging. The private sector had stopped borrowing.

The theory behind Keynesian counter-cyclical policy is that government can offset the lack of private sector for credit by borrowing far more than usual. Over the last 5 years, the federal government's counter-cyclical stimulus program added $9 trillion to the nation's debt. During that time, however, the private sector scarcely grew at all.

Debt can only increase output if it is used to build new productive capacity. If you spend it on Medicaid and wars, it is gone forever. The private sector ends up with a heavier burden...and a weaker back to carry it. Even when the debt is used by the private sector it is often merely used to boost consumer spending. What's more, the Fed's ultra-low lending rates often lure capital into unstable and dangerous investments - such as shale oil or subprime auto loans. So, much of the credit going to the private sector is also wasted. Private sector growth rates have gone down since the '70s. Shackled to trillions in debt, duct taped with regulations and restrictions, deceived by phony financial signals from central banks...they will probably remain low and sink lower for the foreseeable future.

Grow your way out of debt? Not likely.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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